Panics

Panics

Panics are social-psychological reactions to fear. Financial panics occur when investors react to the fear of capital losses by dumping assets, thus causing the collapse of a financial institution or financial market. Moral panics, as Stanley Cohen (1972) coined the term, are situations in which the public expresses not fear but righteous indignation in opposition to a deviant activity of a subgroup, perceived to threaten society and its values. As either social-psychological reactions or financial events, panics are commonly thought to evoke irrational escape-mob behavior—such as stampeding to escape a threatening situation—when rationally one would have less chance of injury with an orderly exit.

Exits in financial panics involve the mass conversion of real or less-liquid financial assets into liquid (or more-liquid) assets, typically money instruments. A sudden high volume of selling—as investors scramble to escape further anticipated capital losses—can abruptly depress or cause a “crash” in the price of illiquid assets. Financial panics known as bank runs entail the mass withdrawal of bank deposits precipitated by a fear that the bank may be unable to meet such a demand in the future. The bank run may be either a lobby run—with retail depositors lining up to convert bank deposits into cash—or it may be an attempt by wholesale and other institutional depositors to transfer funds out electronically. Such fears of illiquidity can, by forcing a distress sale of assets to meet liquidity demands, cause illiquidity and insolvency. As in all financial panics, a fear that the event will happen motivates action that increases the likelihood of the feared event occurring.

A run on a bank that forces insolvency and the suspension of credit facilities, or a market crash that impedes the operation of a significant financial market, heightens the risk of an economic crisis. The breakdown of a market or the sudden withdrawal of credit can adversely affect, on a large scale, the day-to-day commercial operations of organizations in the nonfinancial sectors of the economy. As Milton Friedman and Anna Schwartz (1963) suggest in their explanation of the Great Depression of the 1930s, financial panics can precede, both temporally and causally, economic crises in employment, production, and trade—crises that may extend well beyond the boundary of the original panic. The possibility exists, however, that causality runs instead from economic activity out to money and credit, as Peter Temin (1976) suggests. The historical evidence is sufficiently ambiguous to leave scope for much debate.

Theories of panics as the manifestation of a “crowd mind” turn on whether the observed collective behavior is contagious, convergent, or emergent. Theories of financial panics parallel loosely these psychosocial theories of panics, though such links most often appear only in motivational narratives.

The idea of a distinct crowd mind was introduced in 1895 by Gustave Le Bon with his psychological law of mental unity. Le Bon posited a view of the crowd as distinctly different from the individuals composing it. Through contagion—the spread of behavior from one participant to another—a distinct and distinctly irrational collective mind is formed. Special characteristics of crowds include “impulsiveness, irritability, incapacity to reason, the absence of judgment and of the critical spirit, the exaggeration of the sentiments, and others besides” (Le Bon 1896, bk. 1, chap. 2, p.17). In contagion theories of panics, the “individual” is lost, transformed into a member of a “herd,” acting irrationally in the common-sense meaning of the term articulated above.

Douglas Diamond and Philip Dybvig (1983), in the tradition of Friedman and Schwartz, model bank runs as an equilibrium outcome of random withdrawal and contagious panic. In their model, a sufficiently large withdrawal of bank deposits can threaten bank liquidity, spark a fear of insolvency, and thus trigger a bank run that in the absence of deposit insurance or some other means to ensure reimbursement will yield the feared outcome.

Rejecting Le Bon, Floyd Allport (1924) posited that the crowd mind was simply the aggregated, possibly intensified, feelings of individual participants subjected to the same external stimulant. Like-minded people converge to a crowd rationally in the sense that the crowd mind is wholly consistent with independent individual preferences. Unlike contagion theories, no transformation takes place, and observed similarities across crowd participants cause the collective, not vice versa.

Some authors have attempted to explain financial panics as the result of rational convergent behavior on the part of individuals who fear bank-system insolvency because of some external financial shock. Charles Calomiris and Joseph Mason (1997), for example, suggest that when depositors can observe a financial shock that threatens bank portfolios but cannot identify which banks are at risk, they run collectively on all banks. This asymmetric information theory of bank runs as financial panics is, like Allport’s symbolic convergent theory of crowd minds, “rational” in the sense that the collective run on banks is nothing more than prior shared motivations resulting in the clustering of like-minded depositors acting similarly.

As a third explanation of the crowd mind, the emergent norm theory of Ralph Turner and Lewis Killian (1987) permits convergence insofar as similarities draw people together. But Turner and Killian suggest that there is then the emergence of distinct collective features when unusual situations challenge traditional norms and social interactions shape crowd behavior.

Brenda Spotton Visano (2006) explicitly links the emergent norm theory of crowd mind to a socioeconomic explanation of financial panics. In a framework that adopts a credit theory of the business cycle similar to that which grounds Charles Kindleberger’s (1989) historical study of manias and panics, the panic emerges in a demoralized environment created by the combination of prevailing financial distress and a sudden actual loss of liquidity.

All agree that financial panics involve a substantial and typically abrupt change in asset liquidity. All agree as well that the beliefs of depositors motivate behavior that is self-fulfilling. The debate is over which theory best explains a given financial panic, with history again sufficiently ambiguous, leaving the question wide open for debate.